Technology stocks offer potentially more returns than others but they bear much more risks than people understand, therefore buying tech stocks is not to recommend for the average investors. We tried to explain why in this article.

The Winner Takes It All

Even though those companies play in huge markets, in the technology sector more than in any other sectors, "the winner takes it all”. Let us take the smartphone market to illustrate this. Smartphones are the combination of phones, computers and internet devices. The smartphone market is very young, huge and growing extremely fast:even though this market is not even 10 years old, there are today 1bn smartphone users on the planet. So it is fair to say that it is probably one of the largest and fastest growing markets in the history of mankind:

Such an amazing growth should make the smartphone market attracting to be in, even for smaller players. After all we are talking of the fast growing market in the history of manking, so everybody should want to be part of this new gold rush. BothNokia and Research In Motion remain in the top 5 of this industry and they nonetheless lost money humongous amounts of money in 2011, and 2012. They performed so poorly that people actually feared that they would go bankrupt. On the other hand Apple’s iPhone was broadly recognized as #1 product on this market during this period, which made Apple the most valued company in the world in 2012. As an illustration, the following graph compares the evolution of the stock price of these 3 companies during this period +670% for Apple, -80% for both Nokia and Research In Motion (click here on the graph to be redirected to google finance from which I took this data):

So even though the smartphone market is one of the biggest and fastest growing markets ever, your company risks to file for bankruptcy if you rank only #5? This is what I call a “winner takes it all” business!

Whether it is search engines, laptops, tablets, or game consoles all the market segments of the technology sector show a similar structure: the #1 firm is an extremely profitable company, the #2 much less, and the #5 is close to bankrupcy.

The cool factor

Technology companies produce amazing things. When you go on twitter or watch the news you hear of products that were only described in science-fiction comic books a few decades ago and that most of our parents did not even dream of ever seeing when they were kids: mobile phones with video conference possibilities, cars that can drive without a human driver, computers that recognize you face, encyclopedias that can fit in a device smaller than a packet of cigarettes, companies that have 1 billion customers after less than 10 years of existence, the list goes on. All these inventions and the media attention that they get make us dream, and rightly so. But it also creates a massive inflow of money: when a company makes a breakthrough with a disrupting technology or a new product that can change the way an industry operates, people invest in the technology stocks from this firm, because it appear “cool”. But those investors forget about the value that they get for the price they pay, so they pay too much. The day those companies lose the attention of the medias, their stock prices tend to go quickly down A good example for this is Facebook which stock price lost half its value in less than 3 months while the company was still seeing huge growth in customers and turnover: Facebook’s stock price went down from $38 per share on May 18 2012 to $20 per share on August 02 2012.

The stock prices move at the speed of light

In today’s market the stock prices literally move at the speed of light. Trading robots (computer programs) are able to react to change of prices in less than a millisecond, to take advantage of the smallest mispricing seen in the market. And when it is not robot moving the prices, there are day traders and hedge fund managers. And they all love technology stocks because they are so risky and have such large company valuations which makes them very easy to trade on most major stocks markets of the world. So because they are risky and are quoted in very liquid markets, technology stocks attract aggressive speculators who push the technology stocks to move even faster.

The prices of technology stocks is extremely volatile in normal condition and it is not uncommon to see HUGE price changes virtually overnight on tech stocks. For instance on Thu Dec 20 2012, Research In Motion Ltd, was worth $14.12 in the evening, at the market close, but on the following day Fri Dec 21 at the same time the stock price was $10.91. This is a 29% decline in 24 hours!

Conclusion about technology stocks

The high-tech companies are driven by visionary geniuses who daily reinvent our life. But there is a difference between this and profitability. Technology companies face an extreme unforgiving competition and the very nature of their business obliges them to continuously make risky investments. Moreover as those companies fascinate us their stocks is usually mispriced by the market, and corrections in the market can be extremely brutal.

All this explains why tech stocks are extremely risky. Therefore we recommend to private investors not to trade online high-tech stocks. On the other hand the huge risk of the high-tech stocks means an opportunity that people do not think of: straddle and butterfly options on tech stocks are interesting. Those options are worth a lot more than the market believes as they give you the possibility to make money during the huge moves of the market. To learn more about options check here.